Horizons, symmetry, Kocherlakota and Wren-Lewis

This is prompted by SWL’s mainlymacro post on Kocherlakota’s comments about the Fed’s objectives.

Kocherlakota and Simon want clarification that the target is symmetric. Simon suspects that the asymmetry in the ECB’s objective implied by the words ‘close to but below’ 2 per cent is partly behind the sluggishness of that institution to loosen policy in the face of weakening inflation and activity. If I were allowed to amend the ECB’s statement of its own objective, I would certainly remove the ‘close to but below’ words.  But my sense is that they were a textual sop to monetary conservatives, and not any longer a significant influence on monetary policy.

However, whether symmetry is desirable is debatable. From an academic perspective, symmetry follows only from the fact that we choose to approximate what would be in the interests of agents in the model with a function that is symmetric.  From a practical perspective, it’s clear to me that deviations below target pose a greater risk to monetary stability than deviations above, because they involve the potential for the conventional policy instrument to get trapped at the zero bound, and require costly, unreliable discretionary fiscal stimulus as a helping hand, and recourse to unconventional measures of still uncertain merit.

Simon comments on the proposal that the objective be clarified such that it’s understood that the Fed targets two year ahead forecast inflation. Simon characterises the BoE as having ‘operated until quite recently what appeared to be exactly this two year benchmark’, plotting a chart that shows the two year ahead forecast pretty close to target through the years of the great moderation.

In my view Simon overstates the influence of the two year horizon.  Policy was conceived of like this in the early days of independence.  Partly because of an exaggeration of the generality of an early paper of Svensson’s that assumed there was a two year lag between a policy change and a change in inflation.  But quite soon afterwards, and particularly once senior people became aware of the unrepresentativeness of that Svensson paper, communication began to stress that the horizon was elastic, and, in fact, depended on the shocks hitting the economy.  During the great moderation years the horizon, if there was one, was less binding.  Shocks were smaller, so the economy would be projected to return to base quicker; and there were fewer trade-off-inducing shocks, requiring fewer conscious forecast deviations from target. It took the crisis to make use of the elasticity always stressed in the horizon.

Simon worries that ‘the 2 year horizon came quite close to having a very damaging impact in the UK’. It might have looked like that from the outside, but inside the Bank of England, I don’t anyone worried about this at all.

Simon also overstates – I think greatly – the importance of the published forecast in the policy process.  That policy follows from the forecast would seem natural, and is required for Simon’s chart of the time series of forecasts to be useful in diagnosing anything about the regime.  But it didn’t work like this.

To explain:  very frequently, one could note MPC members operating with the following logic during the forecast round.  ‘For better or worse, we have got ourselves into the situation where we have to publish a forecast, and people are focusing on the two-year ahead forecast relative to target.  However, I don’t believe the forecast coming out of the model, and I don’t always understand it anyway.  So, I will lean on the forecast judgements to ensure that whatever policy decision I prefer the forecast will be equal to target at that horizon.’  If this were always true, the two-year horizon would not be a constraint on anything, ever.

I think encoding a horizon is problematic, for two reasons.

First, I speculate that the influence of the two-year horizon, such as it was, was to contaminate a forecast process [what’s going to happen to the economy and what should we do about it?] and reduce it to a reverse-engineering process [what are we going to do, and how can we build a forecast so that it looks like that is what we should do?]

Second, in principle, the horizon should depend on what is driving the economy away from target/base. And our understanding of the appropriate horizon is very incomplete.  A crude summary of the key problem is this: the models we have that are used to describe the economy have a much stronger mean-reversion than the actual economy, and imply fast returns to base under optimal policy.  Most policymakers and model practitioners operate with the hunch that this property should be overridden, meaning that time away from target should be more protracted.  But how much more?  I don’t think we are ready to fix a horizon in our monetary frameworks.

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Well or badly measured, falling Eurozone inflation is bad news.

John Kay reminds us in his latest FT column that inflation is a statistical chimera. From time to time, new things are invented or desired, and old things no longer bought, and all the time what we buy gets improved. These and other problems, Kay’s piece argues, complicate comparing prices over time and so we should not obsess too much about the latest numbers for Eurozone inflation.

However, contrary to Kay’s line of thinking, in my view our angst about these published data should not be diminished by recognizing these imperfections.

The first point to make is that these biases are a big deal, and so far research suggests that they weigh decisively in one direction, something one may not appreciate from Kay’s line that ‘there are probably more upward than downward biases’.  One finds estimates of 1-2.5 percentage points on annual inflation, (See, for example, the original and famous Boskin Commission Report,  Hausman’s Journal of Economic Perspectives survey, Robert Gordon, and Mark Wynne specifically on the Eurozone’s HICP).  So 0.3% measured inflation means something like -0.7% to -2.2%.

Paul Krugman has made interesting points about the fact that one should not take comfort from the fact that prices are not actually falling, since ‘lowflation’, inflation lower than expected when nominal debt and wage contracts were signed, is damaging in the same way.  But, recognising that published figures may greatly overstate inflation, these debates are somewhat academic, since we may have left ‘lowflation’ behind some time ago and already crossed the Rubicon of deflation by some margin.

Second, although we don’t know precisely what inflation is, and suspect it is a great deal lower than 0.3 per cent, we do know that it is 1.7 percentage points below the 2% target, a rate that was designed to accommodate reasonable estimates of biases in CPI with the intention of avoiding deflation in true, unobserved prices.  This gap between actual and target, [just like the falling measured inflation], is cause for concern, regardless of the data’s mismeasurement.

Third:  these biases, though large, can probably be taken to be relatively constant from year to year.  So, although the published numbers give a poor read on true inflation, changes in inflation are much more faithfully recorded.  The slow but persistent slide in inflation, despite the ECB’s tardy but substantial measures to loosen conventional and unconventional policy instruments, is rightly taken as suggesting that policymakers have not yet done enough, and that a risk of entering a full-blown Japan-style liquidity trap, with interest rates forever trapped at the zero bound, is considerable.

Fourth, if either these biases are unchanging, or private forecasters take falls in Eurozone CPI to capture faithfully what is going on, (or both), the fall in inflation we watch may lead people to forecast lower true inflation in the future, in which case they will record and experience a rise in the real interest rate.  That is like a policy tightening, raising the cost of borrowing, depressing spending, encouraging saving, and driving true inflation down further, absent some further policy loosening.

Although the Eurozone HICP is not a great device for measuring the power to purchase pleasure over very long periods, like the gap between Nathan Rothschild’s final illness and today, the problems with it are well-known, and relatively unchanging.  Greatly below target and falling measured inflation gives a very good picture of the failings of current policy, and should be cause for much concern.

 

 

ECB and QE: Asking for sparkling water when all they will give you is the miserable punchbowl

Much is being made of the ECB Governing Council’s debates about whether it would ever be prepared to do Quantitative Easing, buying outright member state sovereign bonds.  Draghi and a majority seem in favour of it, but not yet.  It is speculated that about 10 maybe against.

Yet the ECB has already determined to embark on credit easing – taking onto its balance sheet up to 1 trillion euros of private sector assets.

A characterisation of the critics of BoE and Fed unconventional policy is that it was too much focused on buying the assets where one would expect there to be the smallest amount of stimulus resulting.  QE is an exchange of assets that are more similar than in the case of credit easing.  Event study and other analysis showed pretty consistently that buying government securities did raise their prices (lower yields).  But at the same time the evidence that this fed through to the prices of private sector securities is more mixed.  [Some work finds that QE simply increased spreads].  And in the Fed case there is evidence that the purchases of Federal agency debt, a security less liquid despite the explicit nature of post-crisis government guarantees, was more stimulative than purhcases of Treasury debt.  And we don’t know if any of these effects on yields were long-lasting, beause of the difficulties of disengangling the other influences (not least the issuing feast that took place at the same time by the other arms of the public sector).

The standard response to this critique was to accept that buying private sector assets was more stimualtive in the short run, but that it ran too great a risk with the central bank balance sheet, threatening the independence of the central bank, relying on an untested expertise in assessing credit risk, leaving it open to accusations of collusion with the private sector issuers (who might be dinner party guests of the Governors), and so on.

Strange, therefore, that the ECB having embarked on this central bank radicalism – buying private sector assets – is at the same time being bashed for not wanting to do what will really fix the problem, a bit of old fashioned debt management.  (Swapping one default-risk free, zero interest security – reserves – for another – member state debt).

Ah, one might say, therein lies the rub.  The member state debt is not default risk free.  So perhaps QE should in that case be viewed as more radical a step as regards redistributing credit risk.  Although there is no private-to-public risk transfer, there is a redistribution of already socialised risk from sovereigns that can’t bear it to those that can.

If that’s the argument, then two questions follow.

First, why can’t the sovereign risk be alleviated by the credit-easing purchases of the private sector debt?  Since it is in large part the worry that those sovereigns are ultimately on the hook for the private debt that causes them difficulty.  [Either because of an expectation of bailout, or being sunk by the workings of automatic stabilisers if private defaults mounted and local recessions deepened.]

Second, the argument that QE is helpful to alleviate sovereign risk impies that the promise to ‘do whatever it takes’ under the auspices of the Outright Monetary Transactions program isn’t enough.  I argued before that this promise was a bluff.  [Because there was no support to take the implied unbounded risk to the ECB’s owners].  But the consensus has been that it wasn’t or that it was a bluff that worked.  But if OMTs have worked, then the argument that QE is necessary to tackle sovereign risk is weak.

Current complaints are like booing because the central bank, just when it sees the party getting going, shouts that everyone should glug as much from the punchbowl as they can, but refuses to serve any more sparkling water and tomato juice.

 

Is the BoE making significant cultural advances post Stockton and McKinsey?

Scott Hamilton at Bloomberg, using a Freedom of Information Request, extracted the results of a staff survey conducted by McKinsey during its high-profile strategic review earlier this year.  [And see my earlier blog on the firework display at Carney’s Mais lecture].

A few remarks.

It’s instructive that the survey results had to be extracted using an FOI request, involving, as Scott reports ‘a seven-month effort’.  The strategic review is meant to be part of a plan  to modernise the Bank and make itself more easily subject to internal challenge.  How odd that in the same process, it makes external challenge and scrutiny difficult, and makes itself look decidedly old-fashioned and defensive by forcing an FOI request for something like this.  The survey [or the report on it] notes that:  “The bank could benefit from a more open, transparent and consultative style of leadership receptive to challenge.”   Quite!  Starting with episodes like this.

Scott reports that ‘the BOE has taken steps to reduce bureaucracy and increase staff engagement.’  Really?  I’d like to know more about those steps.  And how they are bearing fruit.  And I’d offer a few comments.

i)  The Bank has increased the number of Deputy Governors and introduced an extra layer of management in the form of the new ‘Director’ grade, sitting between Head of Division and Executive Director.  How does this help to ‘reduce bureaucracy’?  Arguably, the new ‘One Bank’ vision, which is an application of matrix-management, will require more, not less bureaucracy.  Small units lower down the bank now have to serve more energetically multiple customers at the top of it;  and those multiple customers have to spend more time orchestrating the ‘oneness’ of their demands.  The price of greater oneness might be more, not less bureacracy.

ii) I’d forecast that trying to generate assertiveness and challenge will take a long time to bear fruit.  This lack of assertiveness had at least two causes that I don’t see changing quickly.  One was that on the monetary policy side of the Bank, the chief clients, the MPC, got the amount of assertiveness that it wanted.  A few personalities on the Committee were interested in having their views challenged or changed.  But many weren’t.  But even those that were in principle open to the idea in practice didn’t want it.  It was more important to try to choreograph a resolution of debates between Committee members.  And the last thing they wanted were hand-grenades thrown from the staff.  Moreover, staff knew this, and knew that if they threw those grenades it would ‘politicise’ them as taking sides, making it harder for them to do their job in the future.  (Many of us have received, or been made aware of, incendiary emails from the dissident MPC member of the day accusing us of bias.)  A second cause of the lack of assertiveness and challenge was the relentless incentives placed on those who want to get promoted to change jobs frequently.  Doing this looked good as you could show you had done many different things.  And it gave you a chance to cultivate multiple senior sponsors at the top, and increase the chance that you would get a shot at a promotion when a vacancy arose.  But these incentives mitigated against staying put and accumulating the expertise necessary to mount a credible challenge to MPC members, who were typically people with decades of experience in the field.  I don’t see ‘assertiveness’ bearing fruit quickly because both of these factors seem endemic, and very hard to change.  Moreover, if there is any truth to the reputation that Carney carries around with him, of someone being an effective and ruthless operator in getting his own way [eg in making sure policy is doveish] he will not be a wholly positive factor in enabling the challenge that the Mckinsey review called for.

Anatole Kaletsky, and who was responsible for ‘saving the world’

Here’s a link to my post hosted at ‘Chunomics’, Ben Chu’s blog on the Independent newspaper’s website.  It takes aim at Anatole Kaletsky’s recent article arguing that central banks were a sideshow in the fight against the Great Contraction.

Does trust in money mean trusting there won’t be helicopters?

My ebay copy of Azariades’ ‘Intertemporal Macroeconomics’ arrived in the post today, and, excitedly thumbing through it, trying to work out what had caused the previous owner to scrawl ironic exclamation marks, or underline, I stumbled on a paper by Philip Weil from 1987 I had not known about before.  It’s about the value of money and how it relates to trust in the value of money tomorrow.  The model is an overlapping generations model, where money is a store of value.  People in the model have in their minds that there is some probability that, for reasons unspecified, money won’t have any value tomorrow.  For people to accept money today in return for their goods or labour, the probability they have in their heads that money has no value tomorrow has to be sufficiently small.  You could characterise the debate about whether helicopter money would be an appropriate response to being stuck in a liquidity trap as revolving around what the loud noise of the blades chuffing overhead would do to this subjective probability.  Could such drops be adequately embedded in existing monetary and fiscal institutions and declared objectives that trust is not materially eroded?  Or would they blow it?  As I said before, right now I don’t think it’s worth risking to find out, as we have other levers to pull.  But this Weil paper was, I thought, a nice way to think about the dilemma.

Paul Krugman and Gavyn Davies on secular stagnation

Paul Krugman steps in to clarify the distinction between stagnation in growth rates brought upon by a reduced growth in supply – population, technology, participation – and demand.   His piece was prompted by Gavyn Davies’ reporting on some econometrics that hope to establish whether or not we are experiencing secular stagnation.

First, on Krugman.  I don’t think he quite gets the policy implications of the two right.  In particular, he says that the only thing to do if we have supply-side stagnation is to live within our reduced means [if indeed they are reduced;  lower population growth doesn’t mean slower growth in GDP per head].  By contrast, if the stagnation is induced by persistently weak demand, then we need higher expected (thus actual) inflation, or looser fiscal policy, or both.

However, if stagnation is supply-side induced, then more inflation is warranted.  Let’s suppose that the nominal interest rate consistent with the economy running at full capacity will equal roughly the real growth rate plus the inflation rate.  Higher inflation will be needed, or other wise there will be less room to cut nominal interest rates to fight contractions in demand that will come, superimposed on the slower supply side growth.  Less room to cut rates will mean more and longer episodes at the zero lower bound and more recourse to unconventional monetary instruments of uncertain effect and cost.  And this preventative higher target inflation is needed for the same reason that it would be needed to guard against a future bout of demand-side secular stagnation – allowing deeper and more prolonged monetary stimulus.  So, in fact, the monetary policy implications of the two growth pathologies overlap somewhat.

Second, on Gavyn Davies.  He reports results from a dynamic factor model that show how the underlying, ‘long run’ growth rates of Western economies have been slipping for a long time, and that the poor performance is not just a feature of the crisis.  [Long run in quotes here, because now the long run is something that moves around in the short run].   The factor estimated in the econometrics picks up the thing that the many manifestations of output – not only national accounts data, but survey data, whatever gets thrown into the pot – have in common.  That thing in common seems to be growing at an ever slower rate.  Whether the econometrics helps identify the cause depends on what kind of macro theory you buy into.

If you are a sticky price New Keynesian, and you have digested the analysis of the zero bound and how economies can get trapped there (and taken recent history to vindicate you), and/or you have bought the conjectures of Summers and others about persistently weak demand, and the emerging theoretical support from Eggertson’s recent working paper, then you will not find econometrics like this helpful in identifying causes.  Why?  Because you will be someone who thinks that there can be both persistent demand and supply side influences on output.

If you are a flex price macro person you will think the zero bound pretty much irrelevant to the real side of the economy.   And persistent – in fact any – departures of demand from supply won’t make sense to you.  So the secular stagnation hypothesis, and the necessity of a large and protracted fiscal stimulus to counter it, will not make sense either.  Your reading of a factor model for output will simply be one that distinguishes between high and low-frequency, equilibrium influences.

This factor model’s chart of long-run output growth will only be indicative of its causes if you are a sticky price macro person who hasn’t yet bought the demand-side secular stagnation hypothesis.  In that case you’ll take the view that low-frequency changes in the growth rate of output will be caused by the supply-side.  Since at low frequencies (over long periods) prices can change, equalising demand and supply.